Why FirstRand trades at a premium

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Welcome to the Supernatural Stocks podcast on Moneyweb, with your host The Finance Ghost – your weekly fix of local and international insights for investors and traders.

In the past week, we saw earnings come through from FirstRand and Nedbank. These are companies that are critical to our economy, so it’s worth paying attention to their results.

Nedbank is trying to build a reasonable foundation for growth. Under the new leadership of Jason Quinn, they’ve already made some significant changes to their strategy in Africa. They are also not shy to do deals in South Africa, acquiring iKhokha as a play on the payments space.

They have little choice at Nedbank but to act, as merely sitting back and watching their market share get eroded isn’t going to cut it.

The banking sector is wildly competitive, with new entrants constantly trying to get a slice of the action.

This ranges from fintech-flavoured startups through to the likes of Discovery and their entry into this market.

Read:

Nedbank resets Africa strategy as Ecobank sale trims earnings
Nedbank to acquire fintech iKhokha for R1.65bn

By the way, Discovery Bank is now profitable. Having reached this inflection point, I’m interested to see how quickly they can achieve decent returns on the extensive capital investment to build that bank.

And yet, despite such a competitive bloodbath in banking and the broader financial services sector, FirstRand came out with numbers this week that included some astonishing metrics.

Read/watch:
Adrian Gore: Building a bank is harder than you think
Discovery’s bank bet starts paying off, handsomely
Whose lunch is Discovery Bank eating?

Banking is a highly technical space, but FirstRand has always been the leader among the legacy banks in terms of driving return on capital for investors. This was clearly visible in the latest numbers.

To understand this, we need to cover a few banking fundamentals.

This will give you a better chance of understanding why it is so impressive that FirstRand’s net interest margin (NIM) moved higher in the latest period, or why I was so surprised to see that return on equity (ROE) was up despite an increase in the Common Equity Tier 1 (CET1) ratio.

Let’s deal with some underlying concepts here.

Net interest income: The fundamental banking model

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There are actually only two ways for a bank to make money. Every single thing they do falls into one of two buckets.

The first is net interest income, or NII. This is the traditional banking business that you’re familiar with as someone who might have bought a car through vehicle finance, or a house with a bond. If you have a credit card, you’re paying the bank interest, so you also fall into this line item.

Overdraft? Same. Business loan? That too.

But why is it called net interest income instead of just interest income?

The most fundamental concept in the industry is that banks borrow money from depositors and lend it out to borrowers.

When you deposit your salary in a current account, the bank is taking those excess funds and lending them out. This is why having higher-income earners is valuable to a bank, as there’s a better likelihood of the current account actually having something left after debit orders!

Remember when FNB was offering devices like iPads with its bank accounts during the Michael Jordaan days? They were trying to attract a premium, tech-savvy customer base. This is good for deposits and for digital adoption of banking solutions, both of which are great for profitability.

But banks cannot just operate by lending out your current account funds, as the balances fluctuate daily. So, they offer you money market accounts. The reward for placing your money on deposit with the bank in specific accounts is that you get paid a higher interest rate.

The bank can do this because it is taking your money and lending it out on the other side with more certainty that your balance won’t disappear in an overnight spending spree on your bank card.

If you’re willing to put funds on notice deposit, then that’s even better for the bank. Now you’ve given them more certainty around your money, which means they can make more profit from it. Believe me, the banks are not offering you multi-year notice deposits to do you a favour.

Net interest income captures the differential that the bank makes on funds that it borrows versus what it lends out.

In practice, they borrow in many ways, not just through the retail banking business that you’re familiar with. Corporate deposits, commercial paper – there are many ways for banks to access funds. This is why a banking licence is so valuable.

But what happens when interest rates change?

Have you noticed that when rates go up, your bond suddenly goes up in line with the change from the South African Reserve Bank (Sarb), but your current account doesn’t? And if you have a money market account, your rate might improve slightly, but not to the same extent as the change that the Sarb announced.

This is why banks love an increasing rate environment.

They get to increase the pricing on your loans, while paying you only slightly more (if you’re lucky) on deposits. This boosts net interest margin (NIM).

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There’s another benefit for banks in an increasing rate environment: the endowment effect. They can lend out their equity capital and earn a higher interest rate.

The converse is true in a decreasing rate environment. Margins typically drop in that scenario and so does endowment income, which is why banks have been having a tougher time lately.

Unless you’re FirstRand, it seems. Thanks to better margins on their lending and borrowing business, along with a few heroics in their treasury, they somehow still improved their NIM to 5.09% if you exclude the UK business. And even if you include it, NIM still moved higher compared with where it was last year.

Read:
FirstRand flags possible extra UK provision amid redress scheme dispute
FirstRand’s UK future hinges on motor finance decision, CEO says

Another driver was that their endowment income was actually higher in this period despite the drop in rates, all because they simply had much more equity capital floating around that they could lend out.

FirstRand seems to have a licence to print money at the moment – and it’s because of strategic decisions they’ve made over the last two decades or more.

Non-interest revenue: The source of great returns

I mentioned that there were two ways to make money. We’ve dealt with the first one. We now need to deal with the second one, being non-interest revenue (NIR). This will help me explain the impressive return on capital in the group.

As you probably picked up in the NII section, traditional banking models are capital-intensive.

You need to have money before you can lend it out. Luckily for banks, there are many ways to make money that aren’t directly tied to lending money.

This is where everything from funeral cover through to selling airtime on your online banking comes in. But this is also where you’ll find things like mortgage origination fees, or credit card fees.

Bank charges are in here too, along with the initial fees on your vehicle finance. And in the corporate space, advisory and structuring fees charged by the likes of RMB are critical here.

Yes, some of these fees are adjacent to lending products and wouldn’t exist without them, but others are not. And the ones that aren’t are where the biggest value lies for banks.

If you want to get paid the big bucks in banking, those are the areas you want to work in – where you are the asset, rather than the capital on loan to borrowers, or some kind of technology system that just pumps out the same product over and over again.

Knowledge-based fees are so valuable in banking.

What happens when NIR is doing well? Great things happen in ROE, as NIR does a great job of driving the numerator (returns) without putting pressure on the denominator (equity).

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The denominator brings me to my final point in this brief guidebook to key banking metrics.

ROE: Bringing it all together

The book value in a bank, or the net asset value (NAV), is actually a great anchor for what the bank is worth. With assets and liabilities carried at fair value, the balancing number (equity) becomes useful.

Contrast this to a decades-old manufacturing business where the factories are fully depreciated. The replacement cost is enormous, but you won’t find it anywhere on the balance sheet.

NAV is one thing, but the returns the bank can generate are quite another.

ROE brings this all together, showing you how effectively the bank is using the balance sheet to generate wealth for investors.

If NIM is strong, then capital is being used in a lucrative manner. If NIR is working, then the bank is finding clever additional sources of wealth.

Assuming credit losses and operating costs are well managed, the profits that feed the numerator in ROE will be great. If the bank achieves an ROE that is above the minimum return required by investors, then the bank will trade at a premium to book value.

This is why ROE is one of the most important metrics in banking. It’s exactly why FirstRand trades at a significant premium to Nedbank.

Nedbank’s ROE is just 15.4%, while FirstRand’s is 21.1%. That is a breath-taking gap.

And to top it off, FirstRand increased its ROE from 20.8% in the prior year, despite being on such a high base already. They did this in an environment of decreasing rates, and significant challenges in their UK business. They even did it while the CET1 ratio moved up from 13.6% to 14.4%.

Read:

FirstRand chair on threat of new entrants, Discovery Bank, and collapsing municipalities
FirstRand eyes Ghana, Nigeria growth as lender seeks scale

CET1 is an entire field of study on its own, but it means the balance sheet is in even better shape than before and is carrying less underlying risk. In other words, ROE should technically come under pressure in that environment, and yet it’s gone up.

Better returns with less risk? That’s a masterclass in banking achieved by FirstRand.

And that is why the shares trade at a premium.

Listen/read: Nedbank investors need a bigger boat

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